Monetary stimulus vs financial stability is a false trade-off

There's an idea floating around out there that I fear may be influential. And that idea is horribly wrong. Which makes it dangerous. And I want to try to kill it. But macro is hard. And it's not easy to explain clearly and simply.

I can only try. And I can only hope that others who are more influential than me, or can explain things better than me, will do the same.

"Sure, there's a risk that inflation is falling below target, and a risk that recovery will be delayed, and it would be nice if the Bank of Canada (or Sweden or wherever) could loosen monetary policy to prevent this happening. But monetary policy works by lowering interest rates and encouraging people to borrow more and spend more. And that creates a problem for financial stability, because some people are already borrowing too much. So there's a trade-off between monetary stimulus and financial stability, and monetary policy needs to take both objectives into account."

I made up that quote. But I don't think I made up the influential idea it expresses. And it's horribly wrong. It's almost the reverse of the truth.

One way to attack that idea would be to say that reducing unemployment is a much more important goal than financial stability. That might well be true, but that's not my argument here.

A second way to attack that idea would be to say that there are other and much better ways to address the concerns of financial stability and prevent some people borrowing too much. That too might well be true, but that's not my argument here.

Instead I'm going to argue that the idea is fundamentally flawed.

It rests on a fallacy of composition.

It confuses a consequence with a cause.

It misunderstands the relation between monetary policy and interest rates.

It's just horribly wrong.

1. It rests on a fallacy of composition.

Suppose the Bank of Canada wanted me, Nick Rowe, to spend more, to do my bit to promote recovery and prevent inflation falling below target. So it offers a special rate of interest just for me. Or gets the Bank of Montreal to offer a special rate of interest just for me. If it lowered the Nick Rowe rate of interest I would save less if I were a saver, and borrow more if I were a borrower. Either way I would spend more. (Unless maybe if I were a lender and the income effect of the cut in interest rates making me poorer were bigger than the substitution effect.) The magnitude of the effect on my spending would depend on my interest-elasticity of demand for consumption and investment.

It is awfully tempting, but horribly wrong, to think that if we multiply that individual experiment by 35 million (assuming I'm the average Canadian) we get the macroeconomic effect of a cut in interest rates.

It's horribly wrong because, just for starters, it ignores the Old Keynesian multiplier. If I spend more that means I am buying more from other people, so their incomes will rise, and they will spend more too, which means still other people's incomes will rise...and so on. The macroeconomic magnitude will depend not just on the interest-elasticity but on the marginal propensity to spend (equals marginal propensity to consume plus marginal propensity to invest). And, depending on how long people expect the increased spending and income to last, there is nothing to prevent that marginal propensity to spend being greater than one, which would mean an infinitely big multiplier (until the Bank of Canada sees it needs to reverse course to keep it finite).

It's even more horribly wrong when we think about another accounting identity that holds in aggregate: for every $1 borrowed there's $1 lent. To keep it very simple, imagine an economy where everyone is identical. If I wanted to borrow then so would everyone else want to borrow, which means nobody would want to lend to me, so I wouldn't be able to borrow from anyone else. And to keep it even simpler, imagine that people pay for everything with central bank cash, and that the velocity of circulation is almost infinite and so the amount of cash in circulation is vanishingly small. (Yep, like Woodford's New Keynesian model). If the central bank lowers the rate of interest, people borrow a tiny amount of extra cash from the central bank (they all want to borrow from each other but nobody wants to lend), and spend that cash, and their incomes increase as others spend, which increases their spending even more, and incomes and spending keep on rising until it reaches a level where nobody wants to borrow from other people or from the central bank (or the central bank decides it has increased enough and raises interest rates again).

This is a world in which a cut in interest rates makes people want to borrow, and monetary policy works by making people want to borrow, but there is never any actual borrowing (except for a tiny amount of borrowing cash from the central bank).

Monetary policy does not work by increasing actual borrowing. That is not the causal channel of the monetary policy transmission mechanism. Monetary policy works by increasing spending, not borrowing. And one person's spending is another person's income, so people in aggregate do not need to borrow more in order to spend more. Their increased spending finances itself.

Yep. Macro is hard. You can't just sit back and think "how would I react if my rate of interest fell?". You have to think about how my reactions would affect others, and how their reactions to my reactions would affect me, and so on.

2. It confuses a consequence for a cause.

"Dangerous roads cause drivers to slow down. If drivers slowed down there would be fewer accidents. Therefore, if we made roads more dangerous, there would be fewer accidents."

That argument is clearly invalid. The premises do not entail the conclusion. (OK, the conclusion might conceivably still be true, if safe boring roads and auto trannies lead to distracted drivers texting...). What causes accidents is roads that seem safe, so drivers speed up, but that suddenly and unexpectedly become dangerous.

People are not all identical. At any given rate of interest, some will want to borrow and others will want to lend. So some people will actually borrow from other people. Maybe via financial intermediaries. And some of those financial intermediaries issue liabilities that are used as media of exchange and so are called "banks".

And sometimes some people will borrow too much. Which means, of course, that sometimes some other people will lend them too much. Accidents happen, even on safe roads, because some people drive too fast or aren't paying enough attention. But the biggest accidents happen when an apparently safe road suddenly and unexpectedly becomes unsafe. Because the drivers can't slow down quickly enough. Or even if one driver can slow down quickly enough, another driver who can't simply ploughs into the rear of the slowing car.

OK, that's just an argument by analogy. But I think you can see the link. If central banks keep nominal income growing smoothly, most people will adjust their borrowing and lending (speed) to the prevailing conditions. And some won't, of course. But if the central bank lets nominal income fall, without giving people lots of advance warning, that means that even some otherwise safe borrowers and lenders suddenly become risky, and they crash too. And the best palliative is to get nominal income back onto as close to its previous path as possible as soon as possible. Even if that does cause drivers to speed up, now that the roads are safe again.

3. It misunderstands the relation between monetary policy and interest rates.

As Scott Sumner echoes Milton Friedman: low interest rates does not mean loose monetary policy; low interest rates are a consequence of past and expected future tight monetary policy. That's true both for nominal and real interest rates. If tight monetary policy means actual and expected inflation is low, then nominal interest rates would be low for any given equilibrium real interest rate. And if tight monetary policy means that current and expected future demand and real income are low, then people will want to save rather than counsume, and firms won't want to invest, and so the real interest rate that would equilibrate desired saving and investment will be low too.

So if you want higher nominal and real interest rates, and you want them higher not just today but for the longer term future as part of a sustainable equilibrium, then you need to loosen monetary policy. If inflation and real growth, and hence nominal income growth, are in danger of falling, then you need more monetary stimulus to raise interest rates in a sustainable way.

Microeconomists are fond of saying that the best cure for high prices is high prices. Macroeconomists should be fond of saying that the best cure for low interest rates is low interest rates.

4. It's just horribly wrong.

The idea that more monetary stimulus might be desirable but would unfortunately reduce financial stability, so we shouldn't do it, is a bad idea. It's not enough to say "yes but..", and talk about the costs of unemployment and about other ways of promoting financial stability. There's no "yes" about it. Our answer should be: "No. That idea is horribly wrong".

[I had been thinking of writing something along these lines for some months, ever since I reviewed a draft paper on the idea. Then reading Simon Wren-Lewis' good but depressing post, about Lars Svensson's resignation from the Riksbank, (plus the fact I've now got my grades in), pushed me to write it now. While I generally agree with both Simon and Lars on this issue, I fear that both concede just a little too much to the other side.]

Comments

You can follow this conversation by subscribing to the comment feed for this post.

"But monetary policy works by lowering interest rates and encouraging people to borrow more and spend more. And that creates a problem for financial stability"

There is an element of truth in this statement. If the economy is healthy and unemployment is at its equilibrium level of(say) 5% but for political reasons the govt wants to reduce it to 4% then it may encourage the CB to unexpectedly start increasing the money supply. This may induce a boom accompanied by more spending (some of it financed by borrowing) and reduced unemployment. Eventually (as the unexpected increased become expected ones) the rate of inflation and interest rates may increase. The CB may panic and unexpectedly reduce the money supply and induce financial instability.

So bad monetary policy can cause financial instability. Likewise good monetary policy can help avoid financial instability. If the CB had stood up to the govt and pointed out that if lower unemployment was a desired aim then fiscal and regulatory policy was the answer but that the CB would assist by publicly guaranteeing to hold nominal spending stable during the period when the appropriate policy was implemented then the desired result could be achieved with minimal risk of financial instability.

Starting from a point where nominal spending has fallen below trend then good monetary policy (publicly guaranteeing to get nominal spending back on trend) will increase the likelihood of financial stability while bad policy (unanchored policy that fails to match expectations and delivery) will increase those risks.

Ron: "This may induce a boom accompanied by more spending (some of it financed by borrowing)..."

That bit in brackets is false. None of it, in aggregate, is "financed" by borrowing, because income = spending. What you meant to say is that an increase in borrowing and lending will (very probably) *accompany* the increase in incomes and spending.

"Monetary policy does not work by increasing actual borrowing. That is not the causal channel of the monetary policy transmission mechanism. Monetary policy works by increasing spending, not borrowing."

Well, this certainly makes no sense for the US and Canada, which have cut total debt. The increase in public sector debt has allowed a larger decrease in private sector debt.

In Europe, OTOH, cutting government spending when there is a multiplier greater than 1 has resulted in an increase in government debt. Moreover total debt has increased significantly as a percent of GDP aggravated by the decrease in the denominator.

Still, an increase in rates would worsen the already desperate circumstances of the European banks.

It's not just a question of rates, however. The ECB is dialing back on its unconventional monetary policies and reducing its balance sheet. Given the negative effects of the Cyprus depositor bail-in on confidence, it will probably have to reverse course soon and support the banks, which are still in desperate shape.

So regardless of the theory (and I agree it's wrong), the situation in practice doesn't support a policy of rate increase. [edited as per Peter N's later comment. NR]

Nick — In part one, I think that you need to distinguish between net and gross borrowing by the private sector. Your argument is fine with regard to net borrowing, aggregating the borrowing and lending by private sector actors and looking only at the degree to which the private sector as a whole hold central bank liabilities. But the intuition behind the view you are criticizing is not about what "everybody" or "nobody" does. It presumes a heterogeneous private sector in which some actors' propensity to borrow/dissave in order to spend is more sensitive to interest rates than other actors', so the extra spending engendered by low interest rates creates extra aggregate income which accumulates as saving by the low-sensitivity-to-rates group matched by borrowing/dissaving of the high-sensitivity-to-rates group. There is no fallacy of composition in this story.

I hasten to add that I don't think headline monetary policy should therefore be tempered by financial stability concerns. My view is that we have too few instruments, that in order to get both financial stability and adequate expenditure we need other tools (not "macroprudential" tools or "tough regulation", which will never be sufficient, but income support that renders more spenders dissavers rather than net borrowers). But although you are right to point out that low interest rates don't necessarily induce borrowing concomitant with increased spending, it's not right to day that they logically can't. I suspect that empirically they do.

(I could be mistaken! Unfortunately, it is very difficult to tease out the effect of headline interest rates from a million other variables that affect patterns of lending and borrowing in the one time series we have available.)

"it ignores the Old Keynesian multiplier. If I spend more that means I am buying more from other people, so their incomes will rise, and they will spend more too, which means still other people's incomes will rise...and so on. "

Are you saying that an increase in credit doesn't contribute to an increase in GDP. That is, are you outlining a pure loanable funds model? If so you need to account for this:

Stable monetary environment is good for the creation of jobs and debt (both are long term contracts). Creating jobs and debt in an unstable monetary environment is like sailing in a tiny boat across the Atlantic. Higher employment today increases the risk that employment will be lower tomorrow. The same with debt - more debt today increases the riskmof a deleveraging tomorrow. The only reason we welcome jobs and oppose debt is linguistic. Jobs sound good, debt sounds bad. That's why I am the only person making this argument:
"Sure, there's a risk that inflation is falling below target, and a risk that the output recovery will be delayed, and it would be nice if the Bank of Canada (or Sweden or wherever) could loosen monetary policy to prevent this happening. But monetary policy works by lowering interest rates and encouraging companies to hire more and spend more on wages. And that creates a problem for labor market stability, because some people are already working too much. So there's a trade-off between monetary stimulus and labor market stability, and monetary policy needs to take both objectives into account."

"To keep it very simple, imagine an economy where everyone is identical."

Let's be more realistic. Let's say there is Apple, Warren Buffett, a bank, and 198 other people. Assume Apple and Warren Buffett have large real earnings growth by their monthly budgets and the other 198 have slightly negative real earnings growth by their monthly budgets so they have to borrow to maintain their standard of living. Now run the model. Plus, you will need to model the bank correctly.

To keep inflation from going below target the Bank of Canada can either promote you to spend more or prevent me from producing more. Both you and I have access to credit, I use it to fund production, you use it to fund consumption. Enter a third party - the mercenary. He wants to borrow money from the Bank of Canada to buy guns from me to shoot you. Enter a fourth party - the do gooder. He wants to borrow money from the Bank of Candada to give to you with no strings attached - you don't have to spend it if you don't want to. How does a central bank determine who gets a loan and who doesn't - the consumer, producer, mercenary, and do gooder - just by setting interest rates?

Low interest rates are a consequence of past purchases of interest bearing securities. More buyers than sellers will cause prices to rise (market interest rates to fall) and vice versa. Apparently Scott has never seen an inverted yield curve before. Monetary policy makers can give all the forward guidance they want, unleveraged long term security holders may decide to not sell. Even if holders of long term securities expect future tight monetary policy, that does not mean that they have to change their behavior when it happens. Scott places too much faith in expectations. Just because I expect something to happen does not mean I am going to change my behavior in response to it happening.

I think low interest rates do promote financial instability, at least because they make it harder to value assets: when most of the present value of an asset comes from hard-to-estimate distant returns, that value is going to have a wide confidence interval, and the value may change dramatically depending on ones assumptions. That sets up a situation where small changes can cause people to rush into and out of an asset market, hence financial instability.

Nonetheless, as a first approximation, I think you're right that the tradeoff is false. Monetary policy is like Chinese finger cuffs: the more you try to resist low interest rates, the lower they will end up going. That is surely true in nominal terms in any model with Wicksellian properties: if you keep the interest rate above the natural interest rate, the inflation rate will fall more and more (by definition of "natural interest rate"), and you will end up facing a choice between ever-accelerating deflation and cutting the nominal interest rate even lower than you originally contemplated. It's less clear whether it's true in real terms, but I'm inclined to think it is: the further you get below the target inflation rate, the more aggressive you'll eventually have to be in bringing down the real interest rate to get back to target.

However, the issue of downward-sticky nominal wages complicates the issue. If wages are sticky enough and you start out from a low enough inflation rate, you can go for a long time below the natural interest rate without much decline in the inflation rate. The risk of a deflationary spiral might be extremely small, and, if you think there is a major disadvantage to low interest rates, you might decide to take the risk, keep the interest rate above the natural rate, and just wait for the natural rate to rise on its own (assuming you have reason to believe it will, as I think is the case in many models, due, e.g., to depreciation). So plausibly the trade-off between financial stability and monetary stimulus really does exist.

I think he is or something similar. I don't believe in the for every borrower there is a lender in what I call the strictest sense. "Banks" violate the concept. To see that violation requires doing some accounting of the "banks". When "banks" are added, lower interest rates are about more currency denominated debt. I might be able to come up with a scenario(s) where lower interest rates are still about more currency denominated debt without "banks".

JCE: think about the case where everyone is identical, so there is no way that one person would want to lend if another wanted to borrow, so there could never be any borrowing, because borrowing requires both a willing borrower and a willing lender. Does that mean it is impossible for monetary policy to increase spending? Of course not. People spend the money in their pockets, and that money returns to them when other people spend theirs. So their extra spending is financed by the extra income created by that extra spending. And even if people are not identical, that is still what happens in aggregate. If one person borrows and spends more than his income, then another person must lend, and spend less than his income. For an individual, expenditure = income plus borrowing minus lending. But in aggregate, income = expenditure.

Peter N: you lost me. Sorry. And I'm definitely not outlining a pure loanable funds model. The problem with the loanable funds model (in this context) is that it takes income as exogenous with respect to saving and investment.

Steve: "It presumes a heterogeneous private sector in which some actors' propensity to borrow/dissave in order to spend is more sensitive to interest rates than other actors', so the extra spending engendered by low interest rates creates extra aggregate income which accumulates as saving by the low-sensitivity-to-rates group matched by borrowing/dissaving of the high-sensitivity-to-rates group."

It would need to presume more than just heterogeneity. It would need to presume a very particular form of heterogeneity between those who are currently net debtors and those who are currently net creditors, both with respect to interest-elasticity *and* with respect to income elasticity of desired spending. Because if the central bank cuts the rate of interest, income will rise. (And if I could do math I could figure out what that heterogenity would have to be to get their results.) But to a first order approximation (first term in Taylor expansion stuff) I think that heterogeneity would make no difference whatsoever to the magnitude of the effect of monetary policy. It would be exactly as if everyone had the same as the population averages of interest and income elasticities. And even then, we don't need different interest-elasticities to get gross debt to increase when monetary stimulus succeeds. Take a simple model where everything scales with income. If there is some heterogeneity, so some debt exists, if monetary policy increase income then gross debt will increase in proportion, simply to hold debt/income ratios constant. But this is simply a side-effect of the monetary stimulus, not a causal part of the monetary policy transmission mechanism.

marcus: yep! economists can't but think in terms of trade-offs! But in this particular case, I think the argument for trade-offs is invalid. It's either the "monetary stimulus works by encouraging borrowing" fallacy, or else it's the "let's make roads more dangerous so drivers slow down and have fewer accidents" fallacy.

"let's make roads more dangerous so drivers slow down and have fewer accidents fallacy"

I like the NGDP corridor approach (central path of NGDP +/- 0.5%). Let them change the expected NGDP inside the corridor however they like in pursuit of financial and labor market stability. Minsky argument is that a road too straight generates a bend ahead, this is another argument for a corridor.

Nick, maybe he would support it. On the other hand, an argument can be made that over the long run corridor system could achieve even higher levels of debt and employment if central bank creates bends inside the corridor skillfuly according to a dual NGDP and employment mandate.

I like where this discussion is going, even in its tangents, because these are some issues that have really got me thinking ever since I read this paper-

http://research.stlouisfed.org/wp/2005/2005-020.pdf

- and for the first time encountered some clear & cogent arguments for a very un-British sort of arguments (aside from some I'd come across from Friedman and some hinted at by Nick Rowe).

I'm also interested in hearing some actual arguments regarding the FIH: Nick's analogy to roads is both witty and intelligent. If there's something wrong with the FIH, it seems to me that it's the econophysical nature of it. Macroeconomics has more in common with road planning than astrophysical cycles.

"So if you want higher nominal and real interest rates, and you want them higher not just today but for the longer term future as part of a sustainable equilibrium, then you need to loosen monetary policy. If inflation and real growth, and hence nominal income growth, are in danger of falling, then you need more monetary stimulus to raise interest rates in a sustainable way."

Or you just set nominal interest rates by decree. This can either be done by the monetary authority (the interbank lending rate shall be such and such percent) or by the issuing agent ( U. S. Treasury announced that they are selling 30 year 7% nominal non-marketable bonds. The reason a sovereign can do it while you can't is because the interest payments are funded by a legal requirement called tax revenue. Meaning their revenue carries legal force, while your income does not.

"It's even more horribly wrong when we think about another accounting identity that holds in aggregate: for every $1 borrowed there's $1 lent. To keep it very simple, imagine an economy where everyone is identical. If I wanted to borrow then so would everyone else want to borrow, which means nobody would want to lend to me, so I wouldn't be able to borrow from anyone else."

This is wrong. Most people can handle being both borrowers and lenders, why can't you? I have a mortgage that I am paying off making me a borrower. I have some interest bearing securities making me a lender. I can lend to you and borrow from you simultaneously. I lend to you at a 1 year interest rate of 1% and borrow the same amount for 30 years at an interest rate of 5%.

What you seem to be missing is that there are classes of borrowers who get loans on better terms than others and there is both short term and long term lending and borrowing.

That paper on UK monetary policy history is fascinating. It's hard to remember just how much monetary policy was downplayed. (And you can see the UK 1960's origins of what now calls itself "MMT".)

Frank: you need to understand the Wicksellian indeterminacy problem if you want the central bank to set interest rates at some arbitrarily chosen level. And the government can announce any interest rate it likes on its bonds. But whether or not people would actually buy those bonds at face value is another question, as is the resulting market-determined yield. And I'm not going to spend the time explaining those points to you here and now. You need to do some reading.

"The models we deploy are all grounded in double entry systems of accounts...in which every entry describing an income or expenditure is invariably seen as a transaction between two sectors... However to complete such a system of accounts so that 'everything comes from somewhere and everything goes somewhere', it is essential to additionally include all those flows of funds which show how each sector's financial balance (the gap between its total income and expenditure) is disposed of. It will be then be found that it is impossible to complete the implied matrix of all transactions in such a way that every column and every row sums to zero without calling into existence a banking sector which provides the funds which firms need in order to finance investment, thereby simultaneously creating the credit money which households need to finance transactions and to store wealth." Godley and Lavoie monetary Economics 2nd edition page xlv

I particularly liked the idea that interest rate increases are inflationary: music to the ears of Harold Wilson!

It seems that attempts to control inflation by direct controlling bank credit did nothing to reduce inflation, but plenty to make UK broad money aggregates less than useless.

Anyway, anytime I try to defend what Tim Congdon calls "British monetarism" (which has plenty in common with Post-Keynesianism) I find myself stuck on Thomas Sowell's "thinking beyond step one". So a bank lends to the government and produces a new deposit? Then what? The bank looks to borrow reserves from other banks to meet its liabilities. Then what? The bank that lends now has either eliminated an excess of reserves or is now reserve-deficient. Then what? Eventually, the analysis ends up at the central bank, which is no more lacking control over base money (given that it- prior to 2008- targets interest rates, not quantities of base money) than the Post Office lacks control over stamps because it "targets" the price of stamps rather than the quantity of stamps.

As for the credit-counterparts approach, which made so much sense at first, the Batini and Nelson paper demolishes it in short order.

You are right to draw attention to the fallacy of composition. Every time I seem to have a plausible argument for a position where base money is irrelevant, the fallacy of composition walks over and slaps me in the face.

Andy: I think I would agree with your first paragraph. If the natural rate of interest is low (or maybe low relative to the growth rate?), then small change in r (or r-g) can cause big changes in asset prices. But yes, there's nothing much monetary policy can do about that.

I'm unsure about your last paragraph. Since I think the IS curve is (probably) upward-sloping, I don't think it's right.

W Peden: FIH. Aha!

I can remember that old argument that tight money was inflationary, because it raised costs! I hadn't heard that since 1979. It seemed to make so much sense to people back then. Not just to (some) economists, but to regular folk. It's exactly where you get to with a cost of production theory of prices, plus a fallacy of composition.

Is that what Tim Congdon calls "British Monetarism?" I've always associated the term with the old joke that what the Brits call a "monetarist" is what the Americans call a "sensible Keynesian".

(1) A preference for broad money over narrow money as far as explaining inflation goes.

(2) A focus on interest rates over the monetary base as far as monetary policy goes.

(3) A major role for fiscal policy in controlling the money supply and not just to avoid crowding out. (A deduction from the credit counterparts identity and some apparentely god-awful endogenous money theory.)

(4) A focus on the role of the asset prices in the transmission mechanism from money to the economy and from monetary policy to money. (This is something that Tim Congdon and Gordon Pepper- otherwise very different sorts of monetarist- have in common, I think.)

(5) A belief that public debt management is a major part of monetary policy.

(6) + any monetarist views that do not conflict with the above.

That this was considered radical anti-Keynesianism in the 1970s proves that the joke has a lot of truth in it!

These are an approximation of the real rates in the US from 1990 to date. It's hard to escape the conclusion that the Fed loosened too much or too long in trying to compensate for the dotcom bust (and perhaps tightened a bit too much in trying to regain control).

The federal reserve does not set a real interest rate, it sets a nominal interest rate. You are comparing the result of prior lending (the inflation rate) with the cost of new borrowing / price of existing bonds.

The inflation rate is the result of money borrowed to fund both production and consumption.

"It's even more horribly wrong when we think about another accounting identity ... so I wouldn't be able to borrow from anyone else."

This seems to ignore the form of modern private and central banking. With the switch to inflation targeting via interest rates, coupled with deregulation, the banking sector was set free of most constraints. Banks are special. They create money from thin air that is used to settle transactions. They do so by lending. If you convince the bank that you have a valuable asset then they will loan you money that they can create. The value of the loan backed by your asset is the offsetting transaction. Banks are constrained by capital (not reserves) and profitable loan prospects. Typically it is enough for the central bank to lower rates so as to make the marginal loan more profitable. In a banking crisis the interest rate cut may be insufficient without capital injections into the banking system or restoration of the creditworthiness of borrowers. The fragile aspect of this system is that everything hinges on asset prices. As long as asset prices are rising bank earnings will be sufficient to fund further lending growth (or raising further capital will be cheap). Also, with rising asset prices and it is difficult for loans, especially asset backed loans, to appear risky when asset prices are rising. And we cannot assume that banks are rational actors with perfect information of the future. The future is risky and uncertain. That asset that the bank thought was valuable, may turn out to be worth far less than expected.

The central bank does not control the money supply. The private banks do. The central bank can influence the behavior of the private banks, but they need loan growth and asset price growth to accomplish monetary growth. This system seems destined to suffer from asset price and loan growth that exceeds monetary growth. Eventually the cashflow is insufficient to service the debt, asset liquidation starts, asset prices fall, bank capital falls, loan growth falls (or goes negative) and we have a monetary contraction.

If you agree that the central bank does not control, but can only influence the money supply through the banking system, then you should also agree that banks are important to the macroeconomy. Therefore the asset prices and debt levels are very important.

Andy Behrens: assume the income elasticity of the demand for money is approximately one. Which seems empirically and intuitively roughly plausible. So commercial banks' balance sheets would expand in rough proportion to Nominal GDP. Which means the ratio of banks' assets and liabilities to NGDP would stay roughly the same.

If it lowered the Nick Rowe rate of interest I would save less if I were a saver, and borrow more if I were a borrower.

This is an empirical question, and depends very much on

1) how much wealth the person in question already has
2) what the person's previous plans were
3) how far away they are from retirement/whatever life goal they were saving toward.

Most people, when the rate of interest is lowered, desire to save more, not less. You would expect wealthier people desire to save less, on the margin, and those with less wealth to desire to save more.
That is because they are engaging in buffer stock saving.

As an extreme example, if you were assuming 8% appreciation per annum on your house, and woke up one morning and discovered that your house is worth 30% less, and has an expected future appreciation of zero, then you would save more, not less, if your house was your primary savings vehicle.

In any case, you cannot assume, just because it is theoretically convenient to do so, the shape of savings demands curve with the interest rate.

As another example, suppose you think that there is a non-zero chance that you will be unemployed for one year. So you need at least one year's income saved away to prevent yourself from being forced to sell your house or live in poverty (unemployment insurance is not enough to pay your bills). Here, you will be saving a fraction of your income each period and this fraction goes up as the interest rate declines.

I think these questions depend very much on the distribution of wealth in the economy, and I believe this is why ways of thinking about the economy that seemed to work in the 1980s are ineffectual today.

So commercial banks' balance sheets would expand in rough proportion to Nominal GDP. Which means the ratio of banks' assets and liabilities to NGDP would stay roughly the same.

http://research.stlouisfed.org/fred2/graph/?id=TFAABSHNO

I think the answer is that "income elasticity of the demand for money " is not a meaningful economic metric. Do you mean demand for deposits by households, demand for currency by households, or demand for reserves by banks? The latter is dominated by the availability of new financial clearing mechanisms, such as money market accounts and credit cards. The CB only controls the quantity of reserves, and the demand for reserves as a function of income is dominated by technology and banking sector consolidation, at least over the short and medium term. Over the long term, we don't really care.

One way of thinking about this is that you have two motivations: buffer-stock savings demands and consumption smoothing demands.

As wealth goes to infinity or as the interest rate goes to infinity, the latter effect dominates. As wealth goes to zero and interest rates go to zero, the former effect dominates. In the case of the latter effect, consumption is independent of present income and depends only on lifetime income and the interest rate. In the case of the former effect, consumption is a fixed proportion of current period income only.

if you choose a certainty-equivalent utility function whose derivative is symmetric with respect to the form of uncertainty (e.g. in a model of multiplicative uncertainty, logarithmic utility does the trick, or in a model with additive income uncertainty, quadratic utility is necessary), then the buffer stock savings demand disappears. If you choose a generic HARA utility funciton, then the buffer stock savings does not disappear, and in fact dominates.

Again, this is an empirical question, and low interest rate environments are exactly those when buffer stock savings will be predominant for all except the very wealthy.

"Frank: you need to understand the Wicksellian indeterminacy problem if you want the central bank to set interest rates at some arbitrarily chosen level."

Wicksell I believe was referring to a real (or natural) interest rate realized after money is lent. A central bank sets a nominal interest rate. A nominal interest rate by definition is arbitrary. If I lend you money at a 100% nominal interest rate and you lend it back to me at the same nominal rate are either of us any worse off?

"And the government can announce any interest rate it likes on its bonds."

A government bond auction is structured so that the market sets the interest rate and the government sets the duration. The process can just as easily be reversed so that the government sets the interest rate and the market sets the duration. Instead of you as a market participant saying I bid 7% on 30 year government bonds, you as a market participant say I bid 30 years on 7% government bonds.

"But whether or not people would actually buy those bonds at face value is another question, as is the resulting market-determined yield."

The interest rate on the bond is market determined in an open auction process. The yield to maturity is set as the bond is traded back and forth over its duration. Both the interest rate and the yield to maturity are set in the markets.

When interest rates drop, commercial banks create new money out of thin air and lend it out. To that extent, Nick is correct to say “there is never any actual borrowing” - in the sense that no one need forgo consumption in order for the borrower to consume more.

However, there clearly IS MORE BORROWING in the sense that non-bank entities’ debts to commercial banks have risen. And they’ve risen on the basis of low interest rates. Plus some of those non-bank entities won’t be able to repay when rates rise.

Ergo, Nick’s “never any actual borrowing” point does not invalidate concerns about what he calls “financial stability”. I.e. to put it bluntly, don’t tell me NINJA mortgagors fooled by low interest rates aren’t a problem.

"The bank looks to borrow reserves from other banks to meet its liabilities." So the textbooks say, but in reality? In reality reserve requirements aren't very restrictive. Banks have other sources of funds than demand deposits. The real limits on lending are the ratio of capital to assets at risk, the cost of funds, the availability of credit-worthy borrowers. And, of course, banks sometimes would rather invest than lend.

I have papers from economists about this going back 15 or 20 years. The Fed influences bank lending by using the discount rate to increase or decrease the cost of funds. Assuming a sloping demand curve for loans, and a fairly stable bank margin, increasing the discount rate will decrease the demand for loans as long as banks don't have cheaper sources of funding.

And, of course, as you go up the hierarchy of aggregates from M1 to M4, the Fed's fine tuning ability gets progressively weaker.

I think you didn't look carefully enough at the labels on the graph. It compares two real rates. I'm comparing mortgage rates with the discount rate. I just deflated both by the GDP deflator. That shifts both curves the same amount.

One way of refuting the idea that monetary expansion increases real borrowing is to point out that this is equivalent to saying that monetary expansion increases the current account deficit, which is absurd.

Nick — Mere scaling up of absolute debt would not be a problem. As you say, it would hold heterogeneous agents' debt to income ratios constant, so monetary easing would leave financial fragility unchanged. (I'm setting aside Andy Harlass' interesting point about asset price uncertainty.)

But I think you are mistaken to suggest that you need a very particular model of heterogenous agent to have interest rate policy affect debt (or net wealth) to GDP ratios. I think you'd have a very hard time writing a plausible model in which agents' have heterogeneous sensitivity of expenditure wrt interest rates yet financial strength ratios remain constant as interest rates change. Anyway, the very first model I wrote to try to check this (no mining of the model space, i promise) had showed variations of financial strength with interest rates quite immediately. Maybe we have very different ideas of plausible models! Anyway, I'll try to write this up so you can tell me why I'm wrong.

Nick - in the banking context, how do you factor in the endogenous money aspect? Expansion of bank balance sheets through additional gross borrowing forces a balancing item on the liability/equity side – e.g. deposits at first, at least. So the decision/approval for increased gross borrowing forces a matching form of lending (using your broader meaning of “lending”) as a result. The additional ‘lending’ aspect is involuntary from a macro perspective, because those additional liabilities/equity (e.g. deposits) won’t disappear unless people subsequently start repaying their loans. (It may also result in increased spending from additional deposits as a second order or multiplier effect.) How do you interpret the initial presence of a matching stock of 'lending’ equivalent to the initial borrowing being automatic rather than a voluntary choice under lower rates in the banking context?

Also, in terms of financial behavior that is actually or potentially or not at all a “counterbalance” to borrowing in the context of your post, how do you interpret the technical difference in meaning as between lending and saving?

Steve Waldman: "But I think you are mistaken to suggest that you need a very particular model of heterogenous agent to have interest rate policy affect debt (or net wealth) to GDP ratios."

Sorry. That wasn't what I meant. I was perhaps unclear. I meant: ...affect it in a *particular direction*, so that the level of gross debt/GDP would *increase* if monetary policy loosened. My prior is that that would only happen in 49.999% of parameter space. And gross debt/GDP would decrease in the other 49.9999% of parameter space when monetary policy loosened. (And stay the same in the remaining 0.000001%.) In other words, we can't put a sign on it a priori.

Joe Eagar: Yep. I was wondering about doing the open economy version. And you are right, that in most open economy macro models monetary loosening would depreciate the real exchange rate (in the short run when money is non-neutral) and increase net exports and net lending to foreigners. Good point.

Peter N: "I think this is a simplification too far. You can't model lending with one person lending to herself."

But that extreme simplification forces you to confront the fallacy of composition head on. Which is precisely why I chose it. Who are we all borrowing from? The Martians? Though when it comes to banks, we are, in aggregate, borrowing from ourselves. Because there are two sides to a bank's balance sheet. When we both lend to banks and borrow from banks, we are converting illiquid into liquid (monetary) assets and liabilities. Someone has both a mortgage (where he borrows from the bank), and a chequing account (where he lends to the bank). It is as if he lends to himself, via an intermediary.

Ralph: 7/10 ;-)

See my response about banks immediately above. But remember, if the demand for commercial bank money has an income elasticity of one (which is roughly right), the ratio of bank lending/GDP would not be affected by the expansion in the money supply. And it's not debt, but debt/GDP ratios that matter, for financial stability.

JKH: you lost me a little there, but again see my response about banks just above in this comment.

Frank: " A nominal interest rate by definition is arbitrary."

No it isn't. Please do us a favour. Read a basic textbook, so you would at least learn the language. It would make communication easier.

rsj: interesting. But my gut says that buffer stock ("precautionary") saving would scale too. What you "need" in an emergency for a rich person would be different from what you need in an emergency for a poor person. ("I must keep an emergency stock of caviar/rice".) Plus, this is the individual experiment, not the aggregate experiment.

Ritwik: remember though, Hawtrey was in a world of the gold standard as background. Monetary policy is very different under the gold standard. To a large extent, the gold standard *is* monetary policy.

Again, you move to the individual case, when what's really important in macroeconomics is the behaviour of the system as a whole. In what sense is the cost of funds for an individual bank disconnected from the quantity of reserves?

As for the "banks are capital-constrained" view that some are putting forward: Canada, Sweden, Australia and New Zealand all have no reserve requirements. So why do these banks hold reserves at all? Answer: because their depository liabilities are claims on base money and so they need to hold reserves to meet their liabilities. They have to get their reserves from somewhere; in most times and places, borrowing from the discount window is (to varying degrees) not a first resort, so the bank has to look to the interbank market. However, that's not the end of it: the supplier of reserves to the banking system as a whole is the central bank.

Therefore, whether or not reserve requirements are restrictive ("very" or otherwise) is ENTIRELY irrelevant to whether or not the textbooks are right that banks seek reserves to cover their depository liabilities or that, at the level of the banking system as a whole, the quantity of reserves is under the control of the central bank. Whether or not banks target interest rates in the short-run is similarly irrelevant.

W. Peden: I don't think the "capital constraint argument" suggests that reserves don't have a role. They do, but it is not the money multiplier role. The money multiplier may have been an apt description of reality in the past. Now, the quantity of reserves is completely flexible at a certain cost.

I am sure you would agree that banks are constrained by their capital.

Here is one possible argument for the possible existence of a monetary stimulus-financial stability trade-off: let's call fluctuations in the nominal output of final goods "the business cycle" and let's call fluctuations in the nominal value of ALL goods "the trade cycle". I remember you arguing two years ago that these two cycles can be theoretically separated: changes in PT do not necessarily equal changes in PY.

So monetary policy could be having an effect on the trade cycle that is very different from its effect on the business cycle. Therefore, there can be a trade-off between stabilising the two cycles and, if financial stability is determined by the trade cycle as a whole rather than the business cycle, between (i) monetary stimulus to counter the business cycle and (ii) financial stability.

The simple, non math example is to think of the future value of labor income as a risky asset (except one that cannot be sold). You live for two periods, and have a non-zero chance of being unemployed each period, so the asset may pay out zero. It is like holding a volatile stock, but not shares of all stocks, just one company. Actually just shares in one employee of one company. It is very risky and no one would manage their assets like that if they weren't forced to, but for now, assume that this is the pay off of a generic risky asset.

Now suppose, based on preferences, that the average person wants 50% of the volatile asset, and 50% of the risk free asset to be on their optimal investment frontier, which will correspond to maintaing their optimal consumption path.

But now, given a wage rate of $10, and a market wealth of $5, there is no way that they can achieve this. They are forced to hold twice as much of the risky asset (labor), and so will naturally hold risk free bonds in the other part of the asset, and consume less than they should. They will be off of their optimal (unconstrained) consumption paths, engaging in buffer stock savings.

If you were to give that person 20% more market wealth, and a 20% higher wage, they would save proportionately more of their additional wealth than the perfect foresight consumer, because they really want their market wealth to increase to the present value of their wages, in order to achieve the 50/50 ratio, but expanding both the wage rate and the market wealth doesn't help them do that.

But there is a magic number, namely $10 of market wealth. As soon as they have $10 of market wealth, then they can allocate $10 in safe bonds and have the $10 risky asset, and remain on their optimal consumption paths. Anything above that, i.e. $12 of market wealth, and they choose to purchase $1 of equities and $1 of bonds, preserving the 50/50 ratio of risky and risk-free assets. If they have more than $10 of market wealth, then increasing both their market wealth and their wages will cause them to increase their consumption proportionally.

So you see, there really is a threshhold, below which consumers have one type of savings demands, and above which they have another. That is because we are stuck with labor income and cannot diversify it away. On the other hand, market wealth can be allocated among risky and non-risky assets. We can say that excess savings demands, in such a model, would arise purely out of a bad distribution of market wealth, even if preferences are identical in the population.

Nick Rowe: assume the income elasticity of the demand for money is approximately one. Which seems empirically and intuitively roughly plausible. So commercial banks' balance sheets would expand in rough proportion to Nominal GDP. Which means the ratio of banks' assets and liabilities to NGDP would stay roughly the same.

Empirically, that assumption does not hold. Bank assets have grown faster than NGDP, especially when contingent liabilities are counted.

The Fed doesn't control reserves either. When rates are above the zero bound they are forced to supply the banking system with whatever level of reserves needed to attain their target. The rate is fixed and the quantity is flexible. I think Bernanke has been pretty clear that QE has no effect through the quantity of reserves.

My point is that bank balance sheets are very important as they are vital components of the monetary system. The value of loans/assets and therefore capital, is based upon assumptions about the future cashflow and/or value of assets. Those cashflows and values are risky and uncertain.

Greenspan indicated that the monetary system depends upon the sound judgement of the banking sector as a whole. When that judgement is poor the consequences can be a banking crisis (debt-deflation dynamic). This is troubling because the current policy of the Fed explicitly states that they are trying to inflate/reflate asset prices by inducing risk taking behavior. Is the Fed taking a principled stand that cashflows will be X in the future on a given asset or that someone will pay Y for that asset in the future? Or, assuming that the value of assets does not matter?

I agree that the Fed can ultimately inflate incomes and NGDP to a level to validate any asset price. However, they cannot do it by working through the banking system, as they do at present. They will have to become a direct issuer of money to the economy in some form or another. That is a big change that might take time to occur.

I am aware that central banks set short-run targets for interest rates. That doesn't establish the claim that the Fed has no control over reserves, anymore than "the Post Office is forced to supply stamps at their set price of stamps" implies that the Post Office has no control over stamps. A monopolist can set the price of a good or the quantity of a good; if it sets the price of the good, it still is in control of the quantity, but simply chooses to allow the quantity to vary in accordance with the price rather than vice versa.

So, in the sense of "controlling reserves" that implies a constraint on bank lending (the Fed moves the discount rate, engages in OMOs that vary the quantity of base money, and hits its interest rate target, thereby raising the cost of banks' acquiring reserves to meet their depository liabilities) the Fed controls the quantity of reserves.

As for quantitative easing: it IS an increase in the quantity of base money, so if it has any effect, it's through that increase.

" A nominal interest rate by definition is arbitrary."
" No it isn't. Please do us a favour. Read a basic textbook, so you would at least learn the language. It would make communication easier. "

What definition do you like?

http://www.investopedia.com/terms/n/nominalinterestrate.asp

"Nominal interest rate refers to the rate of interest prior to taking inflation into account. Depending on its application, an inflation and risk premium must be added to the real interest rate in order to obtain the nominal rate."

The reason the nominal interest rate is arbitrary is because the risk premium is arbitrary. See Standard and Poors / Moody's ratings on U. S. mortgages for an example of the arbitrary nature of risk premiums and credit ratings.

"See Standard and Poors / Moody's ratings on U. S. mortgages for an example of the arbitrary nature of risk premiums and credit ratings"

Credit ratings may be arbitrary, but they aren't the same as risk premiums.

As an aside, one of the criticism of rating agencies is that their ratings didn't assess (and didn't purport to assess) certain types of risk, but they nevertheless allowed them to be used as a proxy for overall debt risk. For example, until 2008/09 the rating agencies were happily giving investment grade ratings to notes whose returns were linked to stock indices - i.e., notes that had the same risk profile as equity investments - on the theory that there was no credit risk, which was all that they purported to be rating. But John Q Investor might be forgiven for looking at that investment grade rating and concluding that the investment wasn't risky, when it fact it was. There the criticism was not that the rating was arbitrary, but that they were misleading.

I agree, the Fed could limit the quantity of reserves. If that quantity was a binding constraint then they would lose control over short term rates. That is a thought for another day and would be very disruptive to the banking system as they are not operating under that premise.

I do not think that reserves have power in the other direction at the zero bound. If rates cannot fall and you increase the quantity of reserves, then it has no influence on the lending outcome. The quantity of base money has no effect. The QE effect is through asset prices.

Not "could", "does", under normal circumstances. You can't control short-term rates unless you also can limit the quantity of reserves available to the banking system; a monopolist cannot set a price in its market EXCEPT by controlling quantity. For example, you can't set the price of stamps unless you can also control the quantity of stamps. The Fed must supply base money at the price set, but the price set need not meet the demand of banks for base money, so the quantity of base money is a binding constraint.

How does QE have an affect on asset prices other than via the change in the quantity of base money?

If the banks desired more reserves at a set rate than the Fed was willing to supply, then the rate on those reserves in the effective market would rise. Therefore, actual policy lever or rates would be out of the Fed's control if they did not meet the quantity demanded at their set rate.

"The channels through which the Fed's purchases affect longer-term interest rates and financial conditions more generally have been subject to debate. I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve's purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public. "

Frank: that's what happens when you use Wiki instead of reading a textbook.

Nominal interest rates are what we *observe*. Real interest rates are (with rare exceptions) what we *infer*. And real is defined as = nominal - (actual or expected) inflation. The risk premium is a separate question. The Wiki is misleading you.

http://www.merriam-webster.com/dictionary/arbitrary
2a: not restrained or limited in the exercise of power : ruling by absolute authority

By law, to sell those mortgage backed securities, each bank had to get the securities classified by one of the ratings agencies (Standard and Poors, Moody's, etc.). Because these rating agencies operate as for profit businesses, there is a conflict of interest when a bank pays a ratings agency to rate the bonds that it is trying to sell.

"Credit ratings may be arbitrary, but they aren't the same as risk premiums."

But credit ratings do affect the risk premium. The arbitrary nature of risk premiums arises in part from the arbitrary nature of credit ratings.

Consider the federal reserve. Do they have absolute power in the setting of nominal interest rates? Can the market successfully circumvent the federal reserve in the setting of nominal interest rates?

I'm not talking about a case where the Fed sets a discount rate and doesn't supply at that rate. Why are you?

How does the Fed purchase securities (and thereby change the quantity and mix of non-base financial assets held by the public) without changing the quantity of base money? As I said, quantitative easing IS a change in the quantity of base money. This is achieved by buying securities with base money from the Fed. Therefore, if there is an effect on asset prices, it is via the change in the quantity of base money and therefore the expected future level of base money.

Regarding the upward sloping IS curve. Based on the way the US Treasury market responds to Fed policy, it appears that the IS curve is upward sloping in nominal terms but not in real terms (or at least that's what the market seems to believe). I don't think the data are clear enough to establish whether the slope in real terms is positive or negative, but it's at least plausible that it has the textbook negative slope. Obviously if it has a positive slope, then you're right: the central bank is in complete Chinese finger cuffs, and the only way to keep interest rates up is to threaten to cut them. So you might be right. Indeed I would guess that the slope is close to zero, so there's little the central bank can really do to affect real interest rates. But that's just a guess. A lot of other people who know what they're doing will guess that the slope is negative in real terms, and the data do not refute that guess. In my argument, it is the real interest rate, not the nominal interest rate, that matters for financial stability. So you can say that you disagree with them about a critical parameter value, but people can at least make a coherent (and not empirically refuted) argument that the central bank faces a trade-off between stimulus and financial stability.

I am saying that the quantity is set by demand at a given rate, it is not set by the issuer (the Fed). So banks can have whatever reserves they desire at that rate. The rate is important and the quantity is not. If that is not what you disagree with then I misunderstood you. Sorry.

Under Bernanke's theory, the effect on asset prices is the result of removing an asset from the investable universe. Yes, a quantity of reserves is involved in that transaction. But the effect results from the removal of the asset, not from multiplication or use of the reserves.

Your third sentence is a huge logical leap from the first two. Furthemore, if the quantity that banks can obtain at the given rate is short of what they need to achieve aggregate credit expansion, then ceteris paribus they can't achieve that aggregate credit expansion. The Post Office sets the price of stamps and I can get whatever stamps I desire at that price, but that doesn't mean that I cannot find myself unable to post letters due to a lack of stamps or that my letter posting is not "stamp-constrained".

If I cut off a fish's head with a knife, I have made it more edible. One could say that "the removal of the fish's head has the effect of making it more edible". However, the fact that we can say that doesn't change the fact I have used the knife in cutting off the fish's head. One can't say that the knife had no effect.

Assets are priced in money. Swapping a corporate bond for a government bond doesn't change the money price of bonds, but swapping a corporate bond for money does. The change in the quantity of base money is essential to the whole operation: if the Fed buys a $100 bond with base money and someone burns a $100 note at the same time, would there be a change in equilibrium asset prices?

"How does the Fed purchase securities (and thereby change the quantity and mix of non-base financial assets held by the public) without changing the quantity of base money?"

They pay with t-bills. The difference between t-bills and reserves is economically irrelevant at the ZLB. If one operates a floor or corridor system (pays IOR), then there is no difference away from the ZLB either. Of course, in such a system the CB can control quantity *and* short rate independently. The fact that corridor/floor systems can and do exist and behave, in real terms, just like zero IOR systems, makes a bit of a mockery of the exchange equation and monetarism in general. Just ask yourself how much "money" the Bank of Canada would have to "print" to offset the contractionary effect of setting the short rate at 10%. The fact is, it doesn't matter how much money they "print," there is nothing they can do to offset the contractionary effect of the excessively high real rate. It's exactly the same thing at the ZLB.

I wish had more time to contribute to this excellent debate. Barring that, whatever Andy Behrens and rsj say.

If t-bills become strictly equivalent to base money, then one has a difference with no difference and there's no more need for distinguishing between base money & t-bills than there is between base money and base money less bank notes.

I'd be interested in hearing some more defences of Minsky and the FIH. Nick Rowe's road analogy is devastating for Minskyism and brings the econophysical nature of Minsky's work to the forefront, but I'm sure it's not the last word on the matter.

Let's say reserves and t-bills earn the same and all government debt is t-bills. Are you proposing that the price level is proportional to the (spot?) quantity of government debt + reserves?

If t-bills and base money become strictly equivalent there is no *theoretical* basis to assume that money/t-bills are held to satisfy liquidity demand (rather they are held as savings instruments that earn more than the natural rate) and therefore there is no theoretical link between the quantity and the price level. You can't save the exchange equation by lumping in savings vehicles.

I don't mean to depress you Nick, but I just saw Mark Carney speak here in Edmonton, and he very much disagrees with you:
"The crisis made painfully clear that low, stable and predictable inflation and low variability in activity - especially when associated with exceptionally low and stable interest rates - can breed complacency among financial market participants as risk-taking adapts to the perceived new equilibrium. This dynamic sows the seeds for future, powerful financial instability and (ultimately) instability in output and inflation."
The speech is here: http://www.bankofcanada.ca/2013/05/speeches/monetary-policy-after-the-fall/

Your reasoning is extremely condensed and technical, so I don't really follow it, but I'm sceptical of the claim that there is a juicy decisive argument against monetarism that rests purely on the possibility of IOR, not least because Friedman argued for interest rates on reserves as early as 1959.

You said: "So if you want higher nominal and real interest rates, and you want them higher not just today but for the longer term future as part of a sustainable equilibrium, then you need to loosen monetary policy."

I said: "Or you just set nominal interest rates by decree."
You said: "You need to understand the Wicksellian indeterminacy problem if you want the central bank to set interest rates at some arbitrarily chosen level."
I said: "A nominal interest rate by definition is arbitrary."
You said: "No it isn't."
I said: "Yes it is - see risk premium embedded into nominal interest rate"
You said: "Don't include risk premium in nominal interest rate"
I said: (In response to Bob and W. Peden) - Arbitrary - not restrained or limited in the exercise of power : ruling by absolute authority

This applies to both the rating agencies who are not restrained in the exercise of assigning credit ratings (thus affecting the risk premium) and it applies to the federal reserve who is not restrained or limited in its exercise of power over nominal interest rates (both long term and short term). Some people (like John Taylor) would argue that the federal reserve should be limited to buying and selling short term government securities only, but the federal reserve act isn't written that way.

Would it have made more sense to you if I had said a nominal interest rate set by the monetary authority is by definition arbitrary because the monetary authority has unlimited authority to do so?

Frank: It would make sense to me. But it would be wrong (in Canada today). And it's not my job to explain to you why it's wrong. And certainly not here. Because it's still totally off-topic. So stop now please, because you are disrupting the conversation. And please read a first year textbook.

Andy H: (Thank God for a good on-topic comment.) OK, let's assume the IS slopes down. And that low real interest rates increase the risk of financial instability. Even then, I don't think the argument is clear that there's a trade-off. Because setting the market rate above the natural rate might also increase the risk of financial instability. From my memory of research on mortgage defaults in the 82 recession in Canada, it was unemployed households who had the highest risk of default (unsurprisingly). And if the only thing preventing a deflationary spiral is an irrational psychological resistance to nominal wage cuts, well, that too sounds like a weak safety net that would increase uncertainty. That barrier might be broken. And if it were broken it could be very chaotic. Strikes etc.

"The crisis made painfully clear that low, stable and predictable inflation and low variability in activity - especially when associated with exceptionally low and stable interest rates - can breed complacency among financial market participants as risk-taking adapts to the perceived new equilibrium. This dynamic sows the seeds for future, powerful financial instability and (ultimately) instability in output and inflation."

Interesting. I surmise from the outgoing Governor's comments that from now on the BoC will pursue a Goldilocks monetary policy. Not too predictable - lulling financial market players into a dangerous state of complacency. But not too insanely volatile - with a high risk of sending the economy over the edge all by itself. Just right - cultivating the sense Canadian monetary policy might go "postal" at any moment as a way to keep market players erring on the side of prudence, all the while doing the %2 Inflation Boogie and hoping the SOBs don't notice how stable and well-adjusted BoC types really are.

Hmmm...I have an idea. Maybe the next time the BoC sends a delegation to, say, the OECD they should be instructed to trash their hotel rooms and get themselves YouTubed skinny-dipping in the Seine.

"In exceptional circumstances, when financial imbalances pose an economy-wide threat or where imbalances themselves are being encouraged by a low interest rate environment, monetary policy itself may be needed to support financial stability. Monetary policy has a broad influence on financial markets and on the leverage of financial institutions that cannot easily be avoided. This bluntness makes monetary policy an inappropriate tool to deal with sector-specific imbalances but a valuable one to address imbalances that may have economy-wide implications. As Fed Governor Jeremy Stein has put it, monetary policy “has one important advantage relative to supervision and regulation - namely that it gets in all of the cracks.”"

I'm not sure what Mark Carney is saying here. Yes, monetary policy can be an effective means of stabilizing income and (to some extent) interest rates. And, yes, if the financial environment is one in which intermediaries have taken on an inordinate amount of risk this is certainly something a CB should factor into its decisions. But is he also saying that monetary policy - beyond supervision and regulation - can materially reverse practices that jeopardize financial stability? Is he talking about intentionally adopting a less stable monetary policy to encourage prudence in the financial sector? If not, then what?

Nick, I think the criticisms of using monetary policy are not being well reflected here. Just to sum up with what is "wrong" with monetary policy, as a stabilization tool:

1. land prices are much more sensitive than business investment to cuts or hikes in short term rates. By cutting short term rates and keeping them low, you are shifting the relative price of land versus capital. This is much more distortionary and prone to rent-seeking than fiscal policy. At least with fiscal policy, the risk is that your uncle's construction company gets a windfall. That can be harmful but is benign to having landlords, as a class, get a windfall. Monetary policy is extremely distortionary in an economy in which different asset classes have different durations.

2. As wealth is not distributed evenly, a policy of trying to boost asset prices disproportionately by keeping rates low benefits the wealthy -- more trickle down.

3. Low rates and/or increasing asset prices allow ponzi schemes to survive longer before being uncovered, as they survive until the new investments income coming in is less than the interest payments going out. This promotes instability, as the financial sector always has one foot in the "I am a con, trying to rob you" trench.

Most people would agree that some combination of tax/transfer policies as well as regulation can undo all the drawbacks listed above. So the argument is not that monetary policy should not be used at all. And if you have a really simple model that ignores all of the above -- e.g. a two period model in which everyone is identical and wall street is not a cesspool of coke snorting salesmen, then your model may not properly capture people's concerns. That does not mean that they don't have legitimate concerns.

They just don't see any offsetting tax/transfer policies on the table, and there is general resentment that we are using trickle down policies to try to stimulate the economy, rather than focusing on doing more to directly help those who are unemployed or who've seen their life savings significantly devalued in this crisis.

I've spent a bit of time on NIPA by now, and though I'm far from an expert, I believe the following is correct. The 3 forms of GDP accounting always produce identical figures for GDP and do so by definition.

At all times and in any economic scenario no matter how bizarre or contrived, S = I and GDP = GDE = GDI.

For example, $1000 materializes out of the aether and I use it to pay you to paint a set of coasters bearing likenesses of the great economists. Once you have been payed for the work, GDP = GDI = GDP = S = I = $1000. This is a completely open loop economy and no money is recycled by any mechanism. Still the identity holds as it was defined to.

You can't use something that is true by definition to prove anything about economic mechanism. It is impossible to construct a falsifying counterexample. S = I will hold for Keen and Lavoie every bit as well as it does for you.

If in my economy all investment is funded by the Sun God and later burned by consumers in his honor, it will hold for me.

Nor am I. I *think* he's saying that the BoC should deliberately set the rate of interest above the natural rate, and so push inflation below target, whenever the BoC thinks that people are borrowing and lending "too much". Put a bend in the road to slow down the drivers when they are driving too fast? (Isn't that what the Fed did in 1929?)

rsj: changing the rate of interest is not what "distorts" the economy. What "distorts" the economy is, for example, when the central bank holds the rate of interest fixed when the equilibrium rate of interest changes.

Peter N: "You can't use something that is true by definition to prove anything about economic mechanism."

True. But you can use it to *disprove* theories about the economic mechanism that violate those accounting identities. Which is what I am doing here.

"I *think* he's saying that the BoC should deliberately set the rate of interest above the natural rate, and so push inflation below target, whenever the BoC thinks that people are borrowing and lending 'too much'."

That seems a reasonable interpretation to me...possibly the only one. But imagine the implications...economy at potential, inflation well with the 2% limit, but the BoC decides households are becoming too debt-ridden and banks overextended...time for a made-in-Canada mini-recession to put some worry into the hearts of borrowers/lenders and get them back into line. We restore a proper degree of concern about default risk by creating a situation in which...there's bound to be a lot of defaults. I suppose. And this is preferable to a regulatory response to the "problem" because...?

On the whole, a peculiar position for Carney to have set out...be interesting to see if the new Governor takes up this line.

"But is he also saying that monetary policy - beyond supervision and regulation - can materially reverse practices that jeopardize financial stability?"

For financial stability, the change in interest rate with respect to time comes into play ( dINT/dt ). A change from a 5% to a 4% interest rate is a 20% drop in interest rate. A change from 4% to 5% interest is a 25% rise in interest rate. Ultimately I think you would want interest rate changes to follow a curve rather than a discrete amount of change to promote financial stability.

"For example, you can't set the price of stamps unless you can also control the quantity of stamps."

You have an unusual definition of "control the quantity", I think. You don't need to control the quantity of stamps, merely the quantity at your target price, where that price is the lowest available price. This is not quite the same thing.

The Fed can control lending to the extent it controls the cost of funds and is willing to exert that control. There have been circumstances where the Fed was unwilling to raise rates high enough to cut off speculative lending for fear of the effect on other borrowers. In this case there is no control on total lending.

Control of bank lending through the discount rate depends on the availability of competing sources of funds. Note that the assets at risk to capital ratio requirements from the Basel accords are an independent constraint.

Also bank risk is a macro consideration independent of bank lending. We've seen the damage weak banks can do. The banks in Cyprus were hit by imprudent investment resulting from a flaw in the way European banks calculate risk on bonds from Eurozone sovereigns.

I was really responding to Carney's seeming assertion that keeping borrowers/lenders cautious should be a primary goal of monetary policy. For sure, a CB can keep them cautious...by being unpredictable, inconsistent and abrupt in its policy moves. But these are precisely the kind of behaviours modern central bankers are normally at pains to reassure the public they will avoid. And to see a BoC Governor describe macroeconomic stability/predictability as something that encourages financial players to take on too much risk...makes me wonder what he has in mind.